## L-2 Morning Quiz Q:34

mail2arungoel
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Posts: 29
Joined: Mon Apr 23, 2012 9:45 pm

### L-2 Morning Quiz Q:34

Can u explain step by step the way figures have been computed in Ans to Q34:
for instance all the relevant figures are a percent of sales and sales is growing by 6% then how income is 33K and also other figures are equally puzzeling:
Solution given is :
34. Ans. b) Optimal Capital Structure, debt/equity =0.6, i.e., debt/total capitalization = 0.6/1.6 = 0.375
Cost of debt =10%(new cost of debt after the changing the capital structure of the firm to the optimal capital structure) (HOW?)
Cost of equity from previous question = 17%
Hence the WACC for strategic buyer = (0.375 × 0.1 × (1-0.35)) + (0.625 × 0.17) = 13.06%
FCFF = Net Income + Depreciation + (Interest × (1-tax rate)) – Fixed capital investment – Working capital Investment = 33,000 + 26,400 + (22,000 × (1-0.35)) – 35,200 – 1,100 = £ 37,400
Value of firm = (37,400 × (1.06))/(0.136 – 0.06) = £ 521,632

Arun

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jaspreet.frm
Good Student
Posts: 13
Joined: Mon May 14, 2012 2:42 pm

### Re: L-2 Morning Quiz Q:34

Hi,

Just for the reference, I am typing the question here again,

Richard, CFA is a senior analyst at Quant Equity Research Inc. He has been following the automobiles sector for the past 10 years all over the world. He attends a conference in London where senior analysts of different firms meet and discuss the emerging trends and their impact on various sectors. One of the points raised by Richard is that he believes the returns that can be earned from private companies can be much greater than the returns from similar public traded companies when there is a lot of research that is done about the private company before investing. He says that while valuing a private company the appropriate earnings to be used are normalized earnings. He goes on to make the following statements:
Statement 1: If a real estate asset is owned by the company and depreciated as per historic cost it is likely to overstate the earnings
Statement 2: The normalized earnings of a strategic buyer will always be greater than the normalized earnings for financial buyer
Statement 3: Since the cash flows for private companies are very uncertain, certain items like unusual items and non-recurring items should be included while calculating normalized earnings. Richard is trying to value a private auto parts manufacturer in UK called Automate Inc. He is valuing it from a buyer’s perspective that is likely to benefit from synergies. He has the following data with him:
Risk free rate 4%
Equity risk premium 6.5%
Small stock premium 3%
Marketability risk premium 1%
Industry risk premium 1.5%
Company specific risk premium 2%
Liquidity risk premium 3%
Current debt/equity 0.25
Optimal debt/equity 0.60
Cost of debt 12%
Net Sales £ 200,000
Net Income 15% of sales
Depreciation 12% of sales
Interest 10% of sales
Tax rate 35%
Capital Expenditure 16% of sales
Growth rate of revenue 6%
Change in Working capital 0.5% of sales

He believes that the buyer can increase the sales by 10% due to synergy, the optimal capital structure is expected to be achieved and also the cost of debt is expected to reduce to 10%. After a lot of discussions the board of Automotive Inc. agrees to sell 25% stake in the company to the buyer. The buyer had recently bought a 100% stake in a similar sized company for £ 700,000. Richard believes that a control premium of 24% was paid to this firm and a discount for lack of marketability of 12% is appropriate for Automate Inc.

Explanation

The value of firm would be FCFF of next year(FCFF1)divided by difference between weighted average cost of capital and growth rate(WACC-g)

Cost of debt =10%(new cost of debt after the changing the capital structure of the firm to the optimal capital structure)is given in the question itself. ( I have bold it for you in question body in case you missed it)

It is also given in the question that buyer can increase the sales by 10% because of synergy. So, after investment present year financials would be,

Net Sales £ 200,000+(10%*£200,000)= 220,000
Net Income 15% of sales=15%*220,000=33,000
Depreciation 12% of sales=12%*220,000=26,400
Interest 10% of sales=10%*220,000=22,000
Tax rate 35%
Capital Expenditure 16% of sales=0.16*220,000=35,200
Growth rate of revenue 6%
Change in Working capital 0.5% of sales=0.5%*220,000=1100

Taking above figures and putting the formula for FCFF0: FCFF for present year would be = 37,400.

Since, till now, we are working on present year calculations only, so growth rate has not come picture.
But to calculate FCFF for next year, growth will be taken into account
Therefore FCFF1=37,400*1.06= 39,644

WACC=0.136(as calculated in the solution)

Value of firm=39,644/(0.136-0.06) = 521,632.

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